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Doug Riding, QMI AGENCY

Jul 30, 2014

, Last Updated: 2:42 PM ET

A pension through your work can represent a substantial part of your retirement income, particularly if it is a defined benefit pension plan. This is a plan that provides a predetermined level of income at retirement based on a formula set out in the plan.

Add this income to any money you receive from the Canada Pension Plan and old age security (OAS) and the “fixed income” component of your retirement cash flow can look pretty good.

If you don’t have a pension plan through work, how much do you need to set aside in order to bring your retirement income up to the same level as someone who has a defined benefit pension plan?

Quite often, people I speak with have a magic number of $1 million. For some reason, they’ve held onto the idea that they need at least $1 million in their savings plans before they can retire so they don’t run out of money. This is an arbitrary number at best unless it’s arrived at based on figuring out the math. So let’s do it.

A commonly used formula in defined benefit plans is 2%, times the number of years belonging to the plan, times the employee’s average wage. So if an employee is a member of this pension for 35 years and earns an average income of $65,000, their pension would be 2%x35x$65,000 = $45,500. In this case, $45,500 will be available to the retired employee for the rest of his or her life as long as the pension plan remains solvent.

A typical funding ratio may be 6%, which means the plan will have to set aside approximately $758,333 to fund this person’s retirement income of $45,500 (758,333 x 6%).

If this person’s retirement age is 65 and he or she is able to spend 25 years in retirement before dying, then they will have drawn income of approximately $1,137,500 without accounting for any indexing for inflation. Keep in mind if there is no spouse, there will be nothing left as an inheritance from the pension for any children or grandchildren.

Alternatively, a person who is retiring without a pension at age 65 and is expecting to draw an income of $45,500 until age 90 will have to manage their savings to generate enough return to cover the desired income. If they get 6% return on their savings for the entire 25 years, they would need to have $616,541 set aside to generate $45,500 per year. At 5% return, they would need $673,338 set aside. In either case, they will also have drawn income of approximately $1,137,500 over 25 years with nothing left for the estate.

With the amount of money needed to be set aside to provide the income from a defined benefit plan, it is easy to understand why employees place such a high value on this form of compensation. How much do you need to set aside to generate your retirement income?